How to pick a Good Mutual Fund Scheme using Jensen’s Alpha ratio?

While investing in mutual returns, many people invest taking into account only historical returns. There are several other general factors like ranking, expense ratio, long term performance, consistent performance, etc., However one of the key element is Risk factor. Investors need to analyze carefully about the risk factors involved in the mutual funds. There are a number of tools and ratios that help the investors in investigating about the factors like risk, returns etc. associated with the mutual funds. One of the key method is assessing risk is Jensen’s Alpha Ratio. What is Jensen’s Alpha Ratio in Mutual Funds? How to pick-up a good mutual fund scheme by considering Jensen’s Alpha Ratio?

What are various technical ratios used in picking up a good mutual fund scheme?

There are five technical risk ratios that are often used to rank the performance of mutual fund portfolio – Jensen’s Alpha, Beta, Standard Deviation, R-squared, and the Sharpe Ratio.

What is Jensen’s Alpha ratio?

Jensen’s Alpha ratio is a statistical measurement that shows the return given by a mutual fund or a mutual fund portfolio after adjusting the risk relative to the expected market return predicted by models like the Capital Assert Pricing Model (CAPM). The CAPM formula calculates the rate of return of a certain security or portfolio under certain market conditions. And if the actual return exceeds it, the difference is called as alpha. The higher the alpha, the better is the return of security or portfolio above the predicted level.

Jensen’s measure is a measurable way to determine whether the portfolio manager has contributed something to the value of the portfolio because alpha is attributable to the skill of the portfolio manager rather than the general market conditions.

Jensen’s Alpha Ratio measures the excess return of the fund over the benchmark.

Jensen Alpha Ratio was first used by Michael Jensen in the year 1968 for the purpose of evaluation of mutual fund.

By computing the above formula we will get alpha as 4.4 for this fund.

The positive alpha indicates that the mutual funds have outperformed its benchmark index. In the same way, a negative alpha means that the fund has underperformed from its benchmark index.

How to pick-up a Good Mutual Fund Scheme using Jensen’s Alpha ratio?

If the investor is testing his mutual funds on the Jensen’s Alpha Ratio, he must go with the fund that has high Jensen’s Alpha ratio.

Significance and negative factors in Jensen’s Alpha ratio

Jensen’s alpha is easy to calculate and it rewards the stock selection ability of the fund manager. Jensen’s alpha is important to investors as they need to take care about the quantum of risk involved in achieving that return and not only the total return of the security. For example, if two securities yield identical returns, but one involved lower risk than rationally, the one with lower risk would be preferred.

The biggest negative factor of Jensen’s Alpha is it requires an estimate of beta, which can differ a lot depending upon the source, which in turn can lead to a mis-measurement of risk adjusted return. In some cases, the negative alpha can result from the expenses that are present in the fund figures, but are not present in the figures of the comparison index.

Some good mutual fund schemes in India that have high alpha

Higher alpha gives us an indication of better performance against the benchmark. Below are presented some of the equity mutual fund schemes from large cap, mid cap and small cap. It can be a good parameter for analysis of funds and prove to be very handy for investors.

1) Under Equity Large Cap, Mirae Asset India Opportunities Fund – Direct Plan did well with an alpha of 5.95. SBI Blue Chip Fund – Direct Plan with an alpha value of 4.53 and Kotak Select Focus Fund – Direct Plan with 4.92 also performed well.

3) In Equity Small cap, SBI Small & Midcap Fund – Direct Plan outperformed with an alpha of 18.65. DSP BlackRock Micro Cap Fund – Direct Plan and HDFC Small Cap Fund – Direct plan with an alpha of 12.86 and 12.15 respectively did well in the small cap segment.

Should you consider Jensen’s Alpha ratio in choosing a good mutual fund scheme?

We are considering several parameters in choosing a good mutual fund scheme. Considering risk assessment as another factor in choosing a good fund would always be better. However, don’t go overboard and consider only this factor. This should be considering as one of the several parameters you might be considering while investing in a good mutual fund scheme.

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Suresh KP i.e. me, have written 1800+ articles on this Blog. I love doing analysis on various Best Investment Plans like mutual funds, Stocks, IPO’s, NCD Bonds, Insurance products. If you like our blog, you can share some of the good articles on your Facebook or Twitter. This would be the BIGGEST gift which you would be giving to us.